To the surprise (and dismay) of taxpayers and practitioners, Congress has been unable to repeal or defer the requirement to capitalize and amortize research and experimental (R&E) expenses under Internal Revenue Code Section 174. While there was strong bipartisan support, and a huge lobbying effort from many different industry groups, Congress was unable to pass legislation addressing the issue before the year and does not appear ready to address tax matters anytime soon.
The Tax Cuts and Jobs Act of 2017 (TCJA) included a provision, which was effective for tax years beginning after December 31, 2021, requiring the capitalization and amortization of R&E expenses. Prior to this, such expenses were allowed to be deducted as incurred. The amortization period is five years for domestic research expenses and fifteen years for foreign research expenses. In year one, the mid-year convention is followed, therefore only ½ of the annual amortization expense is recognized in the first year. The TCJA also specifically added software development to the definition of R&D expenditures under Section 174.
This change impacts any taxpayer with R&E expenses. There are no de minimis exceptions included in Section 174. R&E expenses include all expenses incurred for activities intended to discover information that would eliminate the uncertainty concerning the development or improvement of a product.
The impact of the capitalization is merely a deferral of the deduction; however, the current impact can be quite significant. Consider the below comparison for a company treated as an S Corp or partnership for tax purposes. The example below assumes a 6% state tax rate.
|2021 – Full Expensing||2022 – Capitalize and Amortize|
|Total Income Before R&E Expenses||$2,500,000||$2,500,000|
|Amortization of Capitalized R&E||($50,000)|
|Net Taxable Income||$2,000,000||$2,450,000|
|Federal Tax (29.6%)||$592,000||$725,200|
|State Tax (6%)||$120,000||$147,000|
|Total Tax Due||$712,000||$899,200|
In the above example, the taxpayer’s tax liability is over 25% more due to the change in legislation when compared to the prior year. For many taxpayers, especially those with heavy R&E activity, the results could be even more significant.
Is the Research Credit Impacted?
The research credit under Section 41 is not impacted by the requirement to capitalize Section 174 expenses. To qualify for the research credit, expenses must first meet the definition under Section 174. Once expenses meet the definition, they are narrowed down based on other requirements under the research credit regulations. Therefore, it is expected Section 174 costs will be greater than the qualified research expenses used to calculate the research credit. Furthermore, it is possible a taxpayer does not meet the other qualifications required to take the credit but still has expenses meeting the definition under Section 174. In addition, merely forgoing the credit in 2022 does not mean a taxpayer does not have Section 174 expenses.
If a taxpayer has activities qualified for the credit, the credit may be even more important to help offset the increased tax liability as a result of this change.
What Should You Do?
Most taxpayers have never accounted for their Section 174 expenses and may not have properly assessed the impact the rule change will have on their tax liability. The unfavorable tax impact can be mitigated through the R&D credit, so taxpayers may want to revisit such opportunities for the current tax year.
Continue the Conversation
If you have any questions about Section 174 Capitalization and what it means for your business, please reach out. We can help you navigate these new rules. You can also urge your Congressional leaders to take action by sending them a letter through the National Association of Manufacturers.